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Restrictive covenants cannot prevent franchisees from operating in areas where the franchisor has no intention of operating

In MEDIchair LP v. DME Medequip Inc., 2016 ONCA 168, the Ontario Court of Appeal confirmed that a franchisor is not entitled to enforce a restrictive covenant where there is clear evidence it has no intention of operating within the protected geographic area. The finding in this case turned on the existence of “clear evidence” that the franchisor did not intend to operate within the area protected by the restrictive covenant. In order to support efforts to enforce restrictive covenants, franchisors should begin to “paper the record” early with documents that establish areas where franchisors intend to operate and expand.

Facts

MEDIchair LP is a franchisor that operates a network of franchise stores that sell and lease home medical equipment. 2169252 Ontario Inc., Ms. Rolph and Mr. Seiderer (the franchisees) were all subject to a restrictive covenant contained in a MEDIchair franchise agreement. The restrictive covenant, which applied on termination of the franchise agreement, prohibited the franchisees from operating “any business similar to the business carried on by MEDIchair” within a 30-mile radius of their store or the nearest MEDIchair franchise (the Protected Territory) for a period of 18 months.

In June 2011, the MEDIchair franchise system was sold by its corporate owner to Centric Health Corporation (Centric). In early 2012, Centric also purchased Motion Specialties, a group of 24 corporate stores similar to the MEDIchair stores. One of these stores operated within the Protected Territory and competed directly with the franchisees’ MEDIchair store. In September 2014, Centric sold both MEDIchair and Motion Specialties to its current corporate owner, Birch Hill Equity Partners.

The franchisees chose not to renew the franchise agreement when it expired in January 2015. Instead, they removed the MEDIchair signage and continued to operate their business at the same location, using the same merchandise and the same employees. The franchisees also advised their suppliers that they were carrying on “business as usual” under a new name, Living Well Home Medical Equipment. The franchisor brought an application to enforce the restrictive covenant, which the application judge granted. The franchisees appealed this decision to the Ontario Court of Appeal.

The Court of Appeal’s analysis

The main issue before the Court of Appeal was whether the franchisor had a legitimate interest that was entitled to protection by the restrictive covenant. Adopting the test from Payette v. Guay, 2013 SCC 45, the Court noted that the test for reasonableness is whether the clause “is limited, as to its term and to the territory and activities to which it applies, to whatever is necessary for the protection of the legitimate interests of the party in whose favour it was granted” (emphasis added by the Court of Appeal).

In this case, there was clear evidence that MEDIchair did not intend to operate within the Protected Territory. As indicated above, a Motion store, which directly competed with the MEDIchair franchise, was operating in the Protected Territory. On cross-examination, one MEDIchair representative admitted that so long as there was a Motion store within the Protected Territory, a MEDIchair franchise would not be opened in the area. Another MEDIchair representative admitted that there was “no current apprehension or concern that’s relevant to this case about [the franchisees] moving and placing themselves close to any other MEDIchair franchisee, closer than they are today.” Based on the evidence, the Court concluded that “by deciding not to operate in [the Protected Territory], MEDIchair effectively acknowledged that it has no legitimate or proprietary interest to protect within the defined territorial scope of the covenant.” The Court went on to note that this finding was supported by prior case law dealing with restrictive covenants.

Discussion

In determining whether to enforce a restrictive covenant in a franchise agreement, courts are tasked with balancing the integrity of the franchise system with the economic interests of former franchisees. In this case, the application judge had given significant weight to MEDIchair’s argument that the integrity of its franchise system would be compromised if the franchisees were able to avoid the application of their agreement’s restrictive covenant. Although the Court of Appeal acknowledged that the franchisor had “a legitimate or proprietary interest to protect in the goodwill in its MEDIchair system, including the trade secrets, method of operation, contacts and other benefits that are obtained by a franchisee,” the Court was not prepared to accept this broad proposition as a sufficient basis to enforce the covenant in the Protected Territory. It was simply not enough for the franchisor to argue in a general way that it had a legitimate or proprietary interest entitled to protection. Instead, the Court took a more narrow view and examined whether there was actual evidence of a legitimate or proprietary interest requiring protection in the specific territory in question. The Court of Appeal’s decision therefore continues the trend of courts requiring franchisors to provide specific evidence of their legitimate or proprietary business interests at stake, as well as specific evidence of harm to the franchise system before restrictive covenants will be enforced.

Given the Court of Appeal’s decision in this case, when seeking to enforce a restrictive covenant in their franchise agreement, franchisors should turn their minds to whether they have a legitimate or propriety interest to protect in the specific geographic area in question, and, if so, how they can adequately demonstrate this interest to the Court. To that end, franchisors are well-advised to begin “papering the record” early in order to support potential claims of legitimate business expectations that are entitled to protection. Examples of documents that franchisors will want to have on hand in the event a court proceeding is required include internal planning documents as well as promotional materials indicating franchisors’ intended areas of expansion.

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